Options as disguised financings: the demise of an urban tax legend.

TABLE OF CONTENTS I INTRODUCTION 908 II. THE FINANCING RATIONALE 911 III. DOUBTS ABOUT THE FINANCING RATIONALE 913 IV. THE REAL ECONOMIC BASIS FOR UPFRONT OPTION PREMIUMS 915 V. OPTION PREMIUMS AS CPDI WITH NO PRINCIPAL PROTECTION 920 VI. OPTIONS AS INTANGIBLE PROPERTY: THE INCREASING VALUE 925

HYPOTHESIS VII. EXPECTED VALUE--NOT A TRUE SOURCE OF RETURNSON OPTIONS 931 VIII UNEXPECTED RETURNS--THE TRUE SOURCE OF OPTION RETURNS 933 IX. IN-THE-MONEY OPTIONS AND POSITIVE EXPECTED VALUE 937 X. A FINANCE THEORY TEST OF THE "OPTIONS AS FINANCING" 940

THESIS XI. CORRELATION EFFECTS FROM THE PUT-CALL THEOREM 946 XII. CONCLUSION 948

It appears to be an article of faith among leading tax practitioners and academics that the tax accounting rules governing options are obsolete. The rules are viewed as a relic of a bygone era in tax law, hearkening back to the days when concepts of present value accounting were little understood. Much of the tax law has evolved since those days, by adopting rules requiring, inter alia, issuers of debt instruments and their holders to report interest expense and income on an economic accrual basis. The historical tax rules governing options, however, remain strangely ensconced, in seeming defiance of the modern-day trend. Alas, by what logic do these rules maintain their foothold in the modern-day tax realm?

This article reconsiders the mechanics and underlying economics of options transactions with due regard for developments in modern finance theory. This article argues that, notwithstanding the consensus view that there is an implicit financing component to option premiums, the existing rules for options exhibit a remarkably firm grasp of fundamental principles of taxation--including time value of money concepts. Ultimately, this article concludes that current law, insofar as it does not require economic accrual of interest on option premiums, accurately reflects the underlying economics of options and should be retained not merely because the rules are longstanding and deeply entrenched, but because they are fundamentally right.

I. INTRODUCTION

According to the conventional wisdom, there is a hidden financing transaction whenever an option contract provides for payment of an upfront premium, as options generally do. Assuming, arguendo, the truth of that proposition, one might have though that federal tax law would require the parties to an option contract to account for the implicit interest on their disguised financing. That it does not impose any such obligation is usually rationalized as a sensible, if economically unwarranted concession to option participants. (1) At best, it absolves them from having to engage in unduly burdensome tax compliance for transactions that are mostly nontax driven. By the same token, however, that seemingly innocuous accommodation has given rise to an unfortunate lacuna in the taxation of financial products, one that has long been the bane of tax lawyers because it appears to run afoul of economic reality.

The problem is that the tax law currently requires the accrual of interest on noninterest-bearing debt instruments, an approach that the Internal Revenue Service (Service) has lately been seeking to extend to total return swaps and other modern financial products. In contrast, certain other types of instruments, including options and prepaid forward contracts, which would seem to offer an equally compelling case for requiring the imputation of interest, have no such requirements. In evaluating the propriety of either of these approaches, one ultimately finds oneself confronting a more basic underlying concern. How can one justify not requiring interest accruals on options, the oldest-known and most basic form of derivative, when debt instruments and other more complex financial products are taxed on an economic accrual basis? That inquiry, in turn, begs an even more fundamental question, one which is the topic of this article. Do options truly give rise to an implicit financing, or is the belief that they do just an urban tax legend?

This fundamental issue has important ramifications for assessing the proper taxation of total return swaps and other relatively new types of derivative financial products, which are suspected of having an embedded financing component. (2) When the Service proposed a complex new regime for taxing so-called contingent notional principal contracts (CNPCs), (3) a nascent financial product category that encompasses total return swaps and other new financial products vastly more complex than traditional options, the proposed regulations contemplated mandating an interest imputation approach. Yet, the proposed rules were met with vast resistance by leading commentators within the tax profession, and most conspicuously by some of their clients in the burgeoning hedge fund world. (4)

To this day, the Service and Wall Street remain at loggerheads on the proper approach to taxing these increasingly vital new financial products, and an end to that impasse is nowhere in sight. Ironically, the Service's suggested interest imputation approach is the very same approach that leading tax academics have long been advocating as the theoretically correct approach to the taxation of options. (5) The question considered here is whether the academic consensus is right, or contrariwise, whether longstanding assumptions about the true nature of options actually miscast these age-old instruments as entailing a disguised financing.

The purpose of this article, in short, is to reassess the traditional view of options as disguised financings. By deconstructing the essential elements of an option, including the reasons why parties enter into options and why they tend to pay option premiums upfront, the article ultimately finds that the traditional view does not accurately reflect the transaction dynamics of option transactions. The principal drawback, in the author's view, to a tax regime that would impute interest income to the option holder or interest expense to the option writer, is its inability to withstand scrutiny under a sophisticated legal and economic analysis.

First, this article relies on principles of contract law to explain why options, perhaps surprisingly, do not truly implicate advance payments. The article proceeds with an analysis of why options are not properly viewed as appreciating assets. In the process, it resolves underlying confusion concerning notions of "future expected value," a term that has wide application in option valuation methodologies, but which, as explained later herein, is a bit of a misnomer. Finally, the article draws on important insights into the fundamentals of options derived from finance theory to demonstrate what finance experts have long fully understood, namely that options do not in fact implicate a financing running from the holder to the option writer.

II. THE FINANCING RATIONALE

From the time that an option is issued until the time that it is either exercised or allowed to lapse, the option writer, rather than the option holder, bears the ultimate tax burden on any investment income generated by the premium. Leading academic commentators have long questioned why this income tax burden should not properly be passed through to the holder. (6) The argument in favor of interest accrual on options, at least as a matter of principle, is seemingly as compelling as it is straightforward. The option writer receives money (i.e., the premium) at the time of grant, which, according to option pricing theory, represents the expected future value of the option discounted at the risk-free rate of return. (7) In other words, the writer receives proceeds that it can use during the term of the option, and has a future liability of equal value, properly discounted for the time value of money, consistent with a financing transaction.

Under the conventional analysis, current law misallocates the income from the option premium because premiums are priced (i.e., discounted) in the expectation that the writer will hold the proceeds throughout the entire term. (8) Accordingly, the party that truly realizes an accretion to wealth from the investment income on the option premium is the option holder, not the option writer. Under the circumstances, it would appear that the option holder, as the true beneficiary of the investment income, should bear the ultimate tax burden with respect to that income.

Under a financing approach (9) to options taxation, the holder of the option would be treated as if she had loaned the writer an amount of money equal to the premium. Since this loan does not bear stated interest, interest income would have to be imputed to the holder, while the writer would have a corresponding amount of interest expense. As a result, the writer's tax burden would be substantially mitigated because the writer's investment income from the premium would be offset by a corresponding interest deduction. If the transaction were characterized in this fashion, the option holder, in its capacity as a lender, rather than the writer (i.e., the putative debtor), would effectively bear the tax burden associated with income from the option premium.